Yields on Italian 10-year government bonds have hit 7%, a watershed figure that many in the markets view as an unsustainable level, despite the announcement by the deeply unpopular prime minister, Silvio Berlusconi, that he will step aside once vital economic reforms are passed.

Bond yields have been flirting with the 7% level for the past week, hitting a succession of record highs as the turmoil in the Italian government continued. Berlusconi lost his majority in parliament on Tuesday, and although he still managed to get a finance bill through, desertions and dissent from his coalition partners effectively called time on his leadership.

With debt totalling 120% of its gross domestic product, and yields on other maturities of debt also above 6%, Italy's economic situation is dire. Reforms have been hard to push through, a task made even more difficult by divisions within the ruling coalition. Berlusconi's exit has been predicted for some weeks, and the more compelling rumours prompted rises in European stocks, as investors clearly saw the prime minister as a barrier to resolving the country's crisis.

Investors in the US reacted well to the announcement, which came after the European markets closed on Tuesday, but the realities of the country's economic situation and the remaining political tangles that still need to be undone before Berlusconi actually leaves office hit the debt markets on Wednesday. The possibility that the transition could drag on, and that early elections - rather than a technocratic interim government - could be the result of the prime minister's resignation, are worrying buyers. Delays to reform would almost inevitably lead to the economy going beyond the point of no return.

"The markets are still concerned about what happens after Berlusconi resigns, because he's making noises that he wants his former justice minister to lead a government. He's talking about early elections. That spooks investors, because that means a couple of months of campaigning, which would leave Italy rudderless at a time when they need a government to start taking additional steps. They need someone who is in charge talking to the IMF and the European Commission," Robert O'Daly, economist at the Economist Intelligence Unit, said.

"This leaves us potentially with a further few weeks where we'll try to second guess the various scenarios. In the short-term this resignation is likely to be positive for Italian debt and risk but the worst case scenario of early 2012 elections can't be ruled out and further out it's not clear that a new Government could fundamentally change the growth outlook which is at the root of the problem," Deutsche Bank strategist Jim Reid said in a note to clients on Wednesday morning.

Some analysts have said that political change will not save Italy, and that a debt restructuring is now likely. Italy's problem is not one of liquidity that can be solved with temporary bailouts, Strategy Economics' Matthew Lynch said - it is one of solvency. The country's debts are now too large and its growth too slow for it to pull itself out of the mire, according to Lynch.

"Even if a new prime minister can push through structural reforms that lift the growth rate significantly – and there is no reason to think they can – that will take years to work. Italy doesn’t have years," he said. "The only way out of the mess is for it too re-structure is debts by voluntary agreement with its creditors, or else to leave the euro, and re-denominate its debts in a devalued lira. The scale of the losses will prompt vast losses across the global banking system."

Eurozone leaders negotiated a 50% write-down on Greek debt in October, but Italy has a far larger debt stock than Athens, and even a marginal reduction in the value of its bonds could have catastrophic effects on the European and global banking sector.
The political forecasting consultancy Exclusive Analysis said on Wednesday that signs are pointing towards defaults in both Italy and Greece, as domestic political stalemate and disputes over international funding mechanisms hold up responses.

With funding for the European Financial Stability Facility still not in place after a disappointing G20 meeting in Cannes, whether or not the European Union will be able to fund a bailout is far from certain. The International Monetary Fund is currently monitoring the reform process in Italy and reportedly offered the country financing last week.